Feb 07 2013

## Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition

Related Unit: IB Economics Unit 4.7 – Balance of Payments (Unit 3.3 in the new IB Economics syllabus)

Topic: The Marshall Lerner Condition and the J-Curve

Learning Goals/Objectives:

Test of prior knowledge:

1. Define ‘price elasticity of demand’ and explain how it is measured.
2. With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
3. Explain how the depreciation of a country’s exchange rate might affect its current account balance. IS THIS ALWAYS THE CASE?
4. How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?

Part 1:

The exchange rate of Japanese Yen in the United States over the last two years:

Take a snapshot of your two-year exchange rate diagram in OneNote, then copy and paste the questions below into the page.

1. Write a brief description of the changes in your country’s exchange rate over the last two years. (2 marks)
2. Focus on two specific time periods from during the last two years: One in which your currency appreciated noticeably and one in which it depreciated noticeably. These could be periods of just a couple of days or longer periods of weeks or more. Highlight these in two different covers in your graph.
3. Describe what is happening to your currency during the two time periods you highlighted in your chart. (2 marks)
4. Explain TWO factors that may have caused the currency to change in value. (2 marks)
5. Given the changes to the exchange rate you identified above, what would you predict would happen to your country’s current account balance over the two periods identified? Explain. Following appreciation – in the short-run and in the long-runFollowing depreciation – in the short-run and in the long-run. (4 marks)
6. Why does the price elasticity of demand for imports and exports increase over time following a change in a country’s exchange rate? (2 marks)
7. Draw a J-Curve showing the likely change in your nation’s current account balance following the period of depreciation of its currency shown in your chart above and explain its shape, referring to your country’s currency. (2 marks)
8. For both the period of appreciation and the period of depreciation you identified above, explain the impact of the change in exchange rates on the following (4 marks)
• a firm that imports its raw materials from the other country
• a firm that exports its finished products to the other country
• consumers who buy imports from the other country
• a firm that produces good for the domestic market and competes with firms from the other country

Part 2:

Read the following article:  . Based on the extracts below, answer the questions that follow.

Some applaud the dollar’s fall because they believe it makes U.S. exports less expensive and that higher demand will cut the trade deficit. The downside of a low-value dollar is that it makes all the imports we consume more expensive, including raw material and parts used by U.S. businesses, and makes it costlier for U.S. dollar holders to travel or invest outside the U.S. A continued drop in the dollar’s value could destabilize the international economy, leading to a worldwide recession.

• Why might the weaker dollar worsen the US trade deficit? Under what conditions would the weaker dollar improve America’s trade deficit? (2 marks)

Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar’s value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit.

The world now is actually on a two-currency standard — the dollar and the euro. China in effect has fixed its currency to the dollar for the last two decades, and the Japanese central bank only allows the yen to fluctuate within a limited range against the dollar.

• How do exchange rate controls by China and Japan reduce the likelihood that a weaker dollar will improve the United States’ current account balance? (2 marks)

So long as the U.S. continues to offer a higher return on capital than its foreign competitors, both foreign banks’ and private investors’ demand for dollars grow, and the current account deficit can be sustained.

• If investments in the United States began earning lower returns relative to investments in other countries’ financial and capital markets, what would ultimately happen to the US balance of payments in its current and financial accounts? Explain (2 marks)

The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”

Nov 09 2012

## Economic arguments for and against a carbon tax

Reuters – Long-shot carbon tax suddenly part of fiscal cliff debate

The article above suggests that during Barack Obama’s second term as president of the United States, the country may begin to seriously consider imposing a tax on carbon dioxide emissions. The justification for such a tax, points out the article, is two-fold:

The aftermath of Superstorm Sandy, which devastated parts of the U.S. East Coast last week, has raised fresh questions about the links between climate change and extreme weather events, which also makes the idea of a carbon tax more appealing.

A carbon tax is a mechanism to charge emitters of greenhouse gases, such as power plants and oil refiners, for each ton of carbon dioxide they emit.

Prospects for such a tax as a way to address pollution and climate are probably dim in a still deeply-divided Congress, but some analysts say the measure would be more attractive if positioned as a source of new revenue.

In fact, a recent report by the Congressional Research Service, suggesting a \$20 per ton tax on carbon emissions could halve the U.S. budget deficit over time.

Such a tax would generate about \$88 billion in 2012, rising to \$144 billion by 2020, the report said, slashing U.S. debt by between 12 and 50 percent within a decade, depending on how high the deficit climbs, the report said.

America’s government budget has been in deficit every year since 2000, meaning the government spends more than it collects in taxes. Fears over the growing national debt and the impact it will have on future economic growth potential have led many in the US government to look for new ways to earn tax revenue for the government, even some ways that have bene considered taboo until now.

In my year 1 IB Economics course this week we have been learning about and evaluating taxes and subsidies in the markets for various goods. Generally, we learn that government intervention in free markets worsens the overall allocation of resources in the market economy, imposes more costs on society than benefits, and therefore leads to a loss of total welfare. For example, a tax on American beef in Switzerland helps keep the price of imported meat high, benefiting Swiss farmers, but overall the higher price of meet and the reduced quantity and variety available to consumers harms many in society to the benefit of the few cattle farmers. Such a tax, it can be argued, creates a loss of total welfare in society, as the tax’s cost outweighs its benefit.

But not ALL indirect taxes (those placed on the production and consumption of particular goods) reduce total welfare in society. A tax on a good that is over-consumed by the free market may actually improve total welfare as the higher cost to producers leads to a reduced supply, higher price, and a reduction in the quantity demanded in the market. A cigarette tax is the classic example. Without taxes on cigarettes, more people would smoke, creating more harmful effects for society, such as the ills of second-hand smoke, higher rates of lung cancer, greater demand for health care and the higher prices that this increased demand create for all of society, even non-smokers. Cigarette taxes are so widely employed by government and accepted by society that there is no debate whatsoever about their use.

But taxes on other goods that create ills for society are highly controversial, and for good reason. Perhaps one of the most debated and divisive tax proposals of recent years has been on the emission of carbon dioxide, a greenhouse gas emitted during the burning of fossil fuels. The main emitters of CO2 in the United States are the country’s electricity generating firms, which burn coal, gas and oil more than any other industry in the country. CO2 emissions are measured in tons, and a CO2 tax would apply to each ton of the gas emitted by fossil fuel consuming firms.

Arguments against a carbon tax

The primary argument against a tax on CO2 emissions is that it would drive up the costs of energy production, leading to higher energy costs for the nation’s households and firms. This boost in prices would increase costs to producers of all other goods and services in the economy, effectively reducing the supply in several key sectors of the US economy, leading to falling national output, more inflation and greater unemployment. American industry would become less competitive with other nation’s producers, leading to more factories closing down and moving overseas, taking American jobs with them.

Such a conclusion requires that a CO2 tax would, in fact, lead to significant decreases in the amount of energy demanded by the nation’s households and firms. In other words, it assumes a relatively elastic demand for electricity. It also assumes that as the price of fossil fuel generated electricity rises, there will be few alternative forms of electricity for firms to switch to. This leads us to the arguments for a carbon tax.

Arguments for a carbon tax

Energy is an essential good that consumers (whether they be households or firms) demand in large quantities regardless of the price. A carbon tax, which increases the cost and decreases the supply of fossil fuel energy, will not significantly reduce the amount of fossil fuel energy consumed in the United States; at least not in the short run, during which there will be very few substitutes for fossil fuel energy available to consumers.

However, one outcome that proponents of the tax hope for is an increase in the demand for alternative energies, such as wind and solar, which do not require the burning of fossil fuels. Such alternatives are not currently price-competitive with fossil fuels, but a carbon tax would make them more competitive, increasing demand for alternative energies and leading to a greater percentage of America’s total energy production coming from wind and solar.

The graphs below show the desired outcome of a CO2 tax on the markets for fossil fuel energy and renewable energies.

Notice that the tax does not lead to a significant decrease in the quantity of fossil fuel energy consumed in the short run. Businesses in the US will face higher costs, but energy costs are a relatively small proportion of most US industries’ total costs. (The biggest cost faced by US firms, not surprisingly, is labor costs). But the highly inelastic demand assures that fossil fuel energy prices will rise, leading to greater interest from consumers in alternative energies. In the graph on the right, we see an increase in the demand for renewables, leading to a greater quantity being produced.

But what might the long-run impact of a carbon tax be on the US energy sector? As we can see in the graph on the right above, greater demand for renewables will drive their prices up, which over time will increase the appeal of renewable energies to the country’s electricity producing giants. Slowly, the number of renewable energy producers will grow, as old coal or gas burning electricity plants are decommissioned and new wind or solar plants are installed. The supply of renewable energies should rise while the supply of fossil fuel energy should decrease. The result is an ever growing percentage of America’s total energy production generated using wind, solar, or other renewable sources of power. The graphs below show the possible long run impact of a carbon tax in the fossil fuel and renewable energy sectors.

Here we can see that in the long-run, the prices of renewable energies and fossil fuel energies will become closer as the supply of energy produced using wind and solar grows, making it more price-competitive and therefore reducing the demand for fossil fuel energies.Presumably, if the outcomes described above come to pass, the proposed carbon tax could lead to meaningful reductions in America’s greenhouse gas emissions over the long run, as the composition of the nation’s energy production slowly transitions away from non-renewable fossil fuels to renewable, non-polluting energy sources.

But what about the other reason the government is considering a carbon tax now? Remember those fears over the national debt and deficit? How effective would a carbon tax be at raising revenue to help the government balance its budget? To determine this, we must look again at the first graph we drew, only examine the impact of the tax on government, not just the market for fossil fuel energy.

In the graph above, we see that the tax creates a large chunk of tax revenue for the government, “about \$88 billion in 2012, rising to \$144 billion by 2020″. These figures seem optimistic, especially if the previous outcome in which the demand for fossil fuel energies falls in the long run comes to pass. But for now, at least from this Economics teacher’s perspective, a tax on carbon is a good first step towards both reducing American’s dependence on fossil fuels and generating desperately needed government revenues.

Nov 01 2012

## Has the Baby Market Failed?

The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a \$1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and \$200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

Sep 28 2012

## Bad crop equals higher incomes for farmers – what’s up with that?

Despite Record Drought, Farmers Expect Banner Year

Listen to the story above. According to the report, farmers in the American Midwest have seen their incomes reach new highs this year, despite the terrible harvest resulting from a nationwide drought.

This is curious. The drought starved crops of water, forcing farmers to harvest in the middle of the growing season, essentially destroying much of their harvest for the year. So the question is, how does a BAD harvest result in GOOD incomes for farmers?

Believe it or not, the answer to this riddle requires an understanding of elasticity; specifically, price elasticity of demand (PED). PED measures the responsiveness of consumers to a change in the price of a good. The PED for a good can be measured between two prices by using a simple formula:

• PED = the percentage change in the quantity of a good demanded divided by the percentage change in the good’s price.

The result of this calculation, which is known as the PED coefficient, will always be a negative number. Why will the PED coefficient be negative? Think back to the law of demand, which states that there is always an INVERSE relationship between price and quantity demanded of a good. Since PED measures how much the quantity demanded changes in response to a particular change in price, the coefficient of PED must be negative, since price and quantity always change in the opposite direction.

So back to our farmers who are enjoying high incomes despite the terrible harvest. What does this have to do with PED? Well, that’s what I want you to figure out. In the comments below, explain how an understanding of price elasticity of demand can help us understand why farmers whose crops were largely destroyed by drought ended up earning higher incomes than they expected.

Sep 02 2011

## How to have your pasta and eat it too – understanding the allocating function of prices in a market economy

Have a look at this article before reading the blog post below: Pasta prices rise after North Dakota loses million acres of wheat to heavy rain, flooding – Associated Press

Prices are determined by the relative scarcity of a good, service or productive resource. This fundamental lesson is one of the first things we learn in a high school economics class. Why are diamonds, which nobody really needs, so much more expensive than water, which everyone needs? The answer lies not in the relative demands for the two goods (clearly, water is far more demanded than diamonds), but rather the relationship between the relative demand and the supply. Between the two, diamonds are far more limited in supply than water, thus they are scarcer and accordingly more expensive.

This lesson applies not only to water and diamonds, but indeed to any product for which there is a market in which buyers and sellers engage in exchanges with one another. Commodities are goods for which there is a demand,  but for which the supply is standardized across all markets. For instance, bicycles are not a commodity, because there are hundreds of different types of bicycles, meaning it is not a standardized product. But steel, which is used to make bicycles, is a commodity since steel is fairly standard regardless of its ultimate use by manufacturers. Cookies are not a commodity, but wheat is, since wheat is a highly standardized ingredient used in the production of cookies.

Commodity prices, like the prices of anything, are determined in markets. Buyers are usually the manufactures of secondary products for which the commodities are an input. Since commodities are traded all over the world, there tends to be a common market price determined by the national or international supply and demand for the commodity. In recent weeks, one very important commodity has increased in scarcity, leading to an increase in the price for the finished product the commodity is used to produce.

Consumers are paying more for pasta after heavy spring rain and record flooding prevented planting on more than 1 million acres in one of the nation’s best durum wheat-growing areas.

North Dakota typically grows nearly three-fourths the nation’s durum, and its crop is prized for its golden color and high protein. Pasta makers say the semolina flour made from North Dakota durum produces noodles that are among the world’s best.

This year’s crop, however, is expected to be only about 24.6 million bushels, or about two-fifths of last year’s. Total U.S. production is pegged at 59 million bushels, a little more than half of last year’s and the least since 2006, according to the U.S. Department of Agriculture.

The cost of pasta jumped about 20 cents in the past few months to an average of about \$1.48 a pound nationwide…

…North Dakota durum fetched about \$15 a bushel this spring but has dropped to about \$11, due to the lack of buying and selling.

Still, that’s about twice what it sold for at this time last year, she said…

“This is one of the few crops we have that can have such an immediate impact on the consumer,” Goehring said. “This year, they will experience higher pasta prices.”

The story above is one played out in countless markets for commodities (such as wheat) and the goods they are used to produce (pasta, in this case) all the time. Due to poor weather and a particularly wet spring, farmers were unable to plant as many of their fields with wheat as they have in the past. Therefore, the 2011 wheat harvest is less than it usually is, meaning the supply of wheat has decreased. However, since there has been no fundamental change to the demand for wheat (we still eat pasta!) the relative scarcity of wheat is greater than in the past. Demand remained constant, while supply fell, therefore the relative scarcity increased.

The value of anything is based on its relative scarcity. In product markets, like that for wheat, value is conveyed by the commodity’s price. As the article says, the price of wheat is currently selling at “about twice what it sold for at this time last year”. At the current price of \$11 per bushel, we can assume that the price last year was \$5.50. However, the price reached as high as \$15 earlier in the summer, indicating that the reduced supply of 59 milliion bushels, which is “a little more than half of last years” (which we’ll assume was around 100 million bushels), caused the price to peak at \$15 this year. All this is a complicated way of saying that as the output of wheat fell, wheat prices rose because demand remained constant.

Additionally, the price of the product for which wheat in an input also rose. Pasta prices have jumped “20 cents in the past few months” to \$1.48. Since the price of wheat is a resource cost for pasta producers, higher wheat prices lead to a fall in the supply of pasta, making pasta more scarce and driving the price up for pasta consumers.

All this can be demonstrated graphically using simple supply and demand analysis.

Based on the figures in the graphs above, the responsiveness of wheat consumer (which are mostly pasta producers) to the rising price of wheat can be easily calculated. Price elasticity of demand (PED) is the measure of consumers’ sensitivity to price changes. It is measured by calculating the percentage change in quantity following a price change divided by the percentage change in price. The quantity demanded of wheat fell by 41%, while the price rose by 272%, meaning that the PED for wheat is 41/272, or 0.15. This is considered relatively inelastic since such a large price increase led to a relatively small fall in the quantity of wheat demanded.

It is likely that if wheat prices remain elevated throughout 2011, next spring farmers across the American Midwest will have a strong incentive to plant more acres of wheat than they have in years past. Assuming the weather conditions improve and the fields are dry enough to grow wheat, it would be expected that a year from now wheat prices will be much lower than they are today, as supply returns to or exceeds historical levels next year. High prices for wheat today have harmed pasta consumers, but in the long run everyone, both pasta producers and pasta consumers, will likely enjoy lower prices thanks to the high prices of today.

This is how the market system works. When resources are under-allocated towards a particular good, as they have been towards wheat in 2011, price rises in response to the good’s increased scarcity. But the higher prices incentivize producers to allocate more resources towards those goods’ production, and over time the supply increases once more, reducing its scarcity and bringing the price back down.

Discussion Questions:

1. Why did wheat become more scarce in 2011, even though the demand for wheat did not change?
2. Interpret the claim that “wheat consumers are relatively unresponsive to higher wheat prices”. Can you think of a reason why this is the case? Can you think of an example of a product for which consumers would likely be much more responsive to a change in the price?
3. How does the high price of wheat and pasta in 2011 likely assure that a year from now, prices will be much lower than they are today, assuming there are not further problems with flooding in wheat growing areas?
4. How do prices “allocate resources” in a market economy? What do you think would have happened to the number of acres farmers would plant in wheat next year if instead of the price doubling this summer, it had been half of what it was in previous years?

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